THE CHOICE OF LEGAL ENTITY

flutheronioneyedSoftware and s/w Development

Dec 13, 2013 (3 years and 6 months ago)

66 views




Peter Franck

Law Offices of Peter Franck

1939 Harrison St., Suite 910

Oakland, CA 946
12

(510)
318
-
6366

1







THE CHOICE OF LEGAL ENTITY


By Peter Franck
1




One of the first decisions you need to make when undertaking a film, video, or similar
project, is which form of legal

entity the project shall take. There are four basic types of
legal entities: The sole proprietorship; the partnership

(limited or general)
; the corporation

(stock and nonprofit)
; and the
l
imited
l
iability
c
ompany.


The type of legal entity you choose wil
l affect several issues related to your project. Here
are some of the more important issues:


Ownership
. The legal entity will be the owner of the film or the video, and it will hold the
copyright, unless it's sold or transferred to somebody else.



Decision Making
. The nature of your entity also affects governance and decision making
of the project. That is, how and when such decisions will be made, who is to make them,
and whether they will be made in advance of the project's inception, or as it go
es along.



Liability
. If something goes wrong with the project, or if a lawsuit is filed, the entity is liable.
The kind of legal entity you have affects the question of liability. The form of entity
determines whether
-

as a result of the project
-

you incur personal liability that puts your
life savings and house at risk, or whether your personal assets remain protected.






1

Copyright 2012

Peter Franck




Peter Franck

Law Offices of Peter Franck

1939 Harrison St., Suite 910

Oakland, CA 946
12

(510)
318
-
6366

2


Investors
. The form of entity will affect how you raise funds and your relationship with
fundraising mechanisms and sources. It
will also, to some extent, affect your credibility
with funding sources. People tend to take you more seriously if you're a corporation, or in
the film wor
ld, a limited partnership or LLC
.



Taxes
. The legal entity will be the entity that's liable for
reporting income for tax purposes.
Corporations must pay taxes. The nature of your entity has tax consequences for all
people involved as investors or owners.

With the other forms, in general
,

profits or losses
flow over to the various owners or members

own tax returns.



THE FOUR TYPES OF LEGAL ENTITIES


A brief overview of the four types of legal entities:


1.
Sole Proprietorship
. If the project is your business, you are doing it yourself, and you
haven't assumed another form of legal entity, then it's a sole proprietorship. In a sole
proprietorship the income of the project goes onto your personal tax return, as do the
losses a
nd expenses. For tax and accounting reasons, you will still want to set up a
separate bank account with separate accounting, but if anything goes wrong, and you get
sued, your personal assets are at risk.




Additionally, a sole proprietorship is almost
impossible to get investment funds for. And
while a single person can get grants through funding agencies like the
San Francisco Film
Society

-

which act as a not
-
for
-
profit fiscal conduit
-

most major funding sources won't
make direct grants to individua
ls.


2.

Partnerships
. If you are doing a project with one, two or more other people, you may
want to form a partnership. A main advantage of the partnership over the corporation
is that it is cheaper to establish and maintain.




There are two forms
of partnership: the General Partnership, and the Limited
Partnership.


a.
General Partnership
. The general partnership is a good framework for
people who are collaborating and deciding what their responsibilities are and
how they're going to make decisions as they go along. This is because the
general partnership is quite flexible, with the part
ners deciding everything
together. In a general partnership, it is not necessary to pre
-
decide issues
concerning potential situations that could arise in the future.





Peter Franck

Law Offices of Peter Franck

1939 Harrison St., Suite 910

Oakland, CA 946
12

(510)
318
-
6366

3


With respect to liability, in a general partnership all partners are personally
liable

for any debts that arise in connection with the partnership. Further,
under the concept of "joint and several liability", any one partner can be
liable for all of the debts of the partnership.



In terms of such liability, the general partnership is a su
itable entity if your
whole life savings are going into the project, and you haven't got much else
to protect. Because, if all your net worth is tied up in a given project,
something goes wrong, and you're sued, you could still file bankruptcy and
dischar
ge your liability for less than it would cost to set up a corporation to
protect yourself from liability.



In regard to taxes, a partnership, unlike a corporation, does not
pay

income
taxes. However it
must file tax returns
, and if it has employees,
must pay
employer taxes. Every partnership files an income tax return, but sends no
check with it, as the bottom line of the partnership tax return is transferred
onto the partners' individual tax returns. By way of example, if there are two
partn
ers and

the partnership has a $5
0,000 profit, $
2
5,000 of that profit is
imputed to each partner, with the individual partner personally paying taxes
on their share of the profits.



b.
Limited Partnership
. In a limited partnership, there are two classes of
par
tners: The general partners, who are the active people, regularly
conducting the business or the project, and the limited partners, who are the
investors. In the limited partnership, the person putting in money is a limited
partner and if the partnership
is properly conducted, and that person doesn't
become too active in the business, they will not be personally liable for debts
incurred by the partnership, their liability remains limited to the amount of
their investment. Such investment may be lost if
things do not go well, or if
the general partners get sued and lack the funds to satisfy the debt.



In terms of the investor's role as a limited partner, if they are fairly
sophisticated about the business and really wish to have some say in it, then
th
e corporate structure

or limited liability company (discussed below)

is
advisable. This is because investors active and regularly consulted in the
business of a limited partnership can lose their protection as limited partners
and subject themselves to pe
rsonal liability.



Often, the limited partnership is the instrument for a single project, with
passive investors putting up the money, and the active people working the



Peter Franck

Law Offices of Peter Franck

1939 Harrison St., Suite 910

Oakland, CA 946
12

(510)
318
-
6366

4

project. The limited partnership agreement is much longer than the general
partnersh
ip agreement because it's a deal between the principals and the
investors. It basically states how the money is going to flow, who is entitled
to what amount of money, and when they can expect to receive the money.


Typically, the investors get first mo
nies, until they recoup t
he amount they
invest.
Under a

common

arrangement
the project
would pay deferred
expenses of the production

net
, i.e., all or a portion of the salary of actors,
directors, producers, etc., who had previously agreed to have such
monies
deferred until the project started to make money. Finally, after investors are
recouped, and deferments paid, the investors and the production company
would split any remaining profits on a fifty
-
fifty basis.




As to taxation, a limited partnershi
p is similar to a general partnership, with
taxes being paid by the partners individually. For example, if in a limited
partnership, if you have a 5% interest because you put in a few thousand
dollars, 5% of the partnership's profits are attributed to you

whether or not
they're paid out, and are reported as income on your personal income tax
return.



If a 5% loss were incurred by the partnership, 5% of its losses would also be
reported on your personal return. However, losses can only be deducted
again
st similar profits. Therefore, if you invest in a limited partnership and
you have a $5,000 loss, if that's the only passive investment you have, you
can't use it. You cannot deduct such a loss against your wages for being a
film editor during the day, f
or example. However, if you're in another
partnership and it makes
$
5,000 profits, those two can be offset against
each other because they are of the same nature.


3.
Corporations
. Corporations have theoretically the greatest protection from personal
liability. In the eyes of the law, the corporation is basically the same as a natural person.
It's dealt with as an independent entity, which can contract, and has liability. The structure
of a corporation is that there are shareholders who are the owne
rs. Usually, in a film or
video project that would be a combination of the investors getting shares for their
investment and the principles getting shares in the corporation employing them. Usually
the project has to come to a certain point of script or
work in progress before you can
attract investors. At that point, the project is then sold to the corporation for shares.
Therefore, under such an arrangement, both the active principals, and the investors, are
shareholders.



The shareholders elect a
Board of Directors which sets policy, the Board of Directors
elects officers who are the people who run the business on a day to day basis. The voting



Peter Franck

Law Offices of Peter Franck

1939 Harrison St., Suite 910

Oakland, CA 946
12

(510)
318
-
6366

5

is calculated on the basis that one share has one vote. The shareholders, whether they be
principals or
investors are not seen to be liable for the debts of the corporation. So you
have
s
trong
protection from personal liability if you use a corporate form. However, to be
sure that this protection really exists, certain formalities need to be followed. The

minute
books should be kept up to date, annual meetings of shareholders and directors should be
held, the corporation must have it's own bank account, and adequate capitalization needs
to be maintained to meet the liabilities reasonably anticipated in a g
iven project. In
general, the more formally the corporation is maintained the greater chance of protection
from personal liability.



While the corporation does offer the shareholder protection from personal liability not
realized under a general partners
hip, a corporation is more costly to establish and
maintain. A corporation must pay a minimum tax of $800.00 to the State of California
every

calendar

year for the privilege of being a corporation. Additionally, a corporation
generally entails more paper
work than a partnership.



In some senses the corporation seems the most flexible form of legal entity because the
Board of Directors can decide issues that may come up as it goes along. In practice
however, it may be less flexible, because the investors
want some understandings before
they put their money in, as to how the money is going to flow. Such understanding
requires a shareholder agreement among all the shareholders which ends up deciding
many of the same things determined in a limited partnershi
p agreement.



In terms of taxation, a corporation not only files a tax return, but also pays

tax on net

income

just like an individual does. Most corporations in the range that we're probably
talking about don't actually pay taxes because they pay salari
es to their principals and
those salaries usually eliminate any surplus. But if the corporation has net income
-

if it
made more money in the year than it spent
-

it pays income taxes just as an individual
would.



A corporation has the option of electing

to be taxed
similarly to
a partnership. This is done
by filing a subchapter S election, (named after a subchapter of the Internal Revenue
Code). There are a few differences in how a partnership is taxed, but basically the
corporation doesn't pay taxes itself. The tax consequenc
es of the Corporation are carried
over to the tax return of the shareholders in just about the same way they would be if they
were a partnership.



Non
-
Profit Corporations
. If you are dealing with a bigger project, funded by grants or
nonprofit donations
, you may want to set up a nonprofit corporation. A nonprofit
corporation is similar to a for
-
profit corporation, except that it cannot sell shares, and there
are no shareholders. The nonprofit corporation can be a vehicle if nonprofit funding is



Peter Franck

Law Offices of Peter Franck

1939 Harrison St., Suite 910

Oakland, CA 946
12

(510)
318
-
6366

6

availab
le. The nonprofit corporation can pay its principals salaries for their work, but
cannot pay anybody a profit. However, the salaries may often be as much or more than
the profits they might make in a for
-
profit kind of structure.



The most common form

of a nonprofit corporation has a Board of Directors, usually
appointed by a founder. The board is then self
-
perpetuating, as terms of the director
members expire, the Board itself picks new members. Some nonprofit corporations are
actually membership or
ganizations like clubs and have members who elect the Board of
Directors.



4. Limited Liability Companies
.
Limited Liability Companies (LLCs, as they are called)
are a
relatively
new form of entity. They are neither partnerships nor corporations but, i
n
fact, something of a hybrid between the two. They are formed by filing with the state a
document called "Articles of Organization." Where a corporation

would have

bylaws, and
a partnership
w
ould have

a Partnership Agreement, the LLC has an

Operating
A
greement.


Essentially the LLC is an incorporated partnership. Neither the manager nor
t
he members of an LLC are personally liable for the debts of the business but the profits
are taxed in essentially the same way as the profits of a partnership (that i
s, the LLC pays
no taxes but the net profits or losses are attributable to the members and show up on their
own tax returns).

An LLC can elect to be taxed like a corporation.



The Limited Liability Company was formed because of certain restrictions on Sub Chapter
S Corporations (remember, those are corporations which are taxed as if they are
partnerships). The restrictions on Sub S corporations relate to the kinds of shareholde
rs
the corporation can have. There are no similar restrictions on LLCs.


Summary
. The choice of form of entity is a balance between considerations of expense,
protection from personal liability, convenience
, where the funding for the project is coming
f
rom,

and
often
most important, taxation.